Understanding Fiduciary Duty in a Company Sale

Your Director Duties in “Moderate Outcome” M&A

One of the most common - and most tricky - tests of whether you know your fiduciary duties as a Director is when a viable company gets an “split offer” where A) some shareholders want the deal, and B) others want to keep running the company.

This situation comes up in an early chapter of Startup Boards (great book!). It’s also happened in on the Delaware court (see in Re: Trados, below).

And it’s probably going to happen a lot in this upcoming recessionary rough-patch.

If you are involved in a startup board, you should be thinking about these questions now so you’re ready to act decisively when the moment comes.

It’s a complicated topic. And yes, even veterans get this wrong.

Should We Accept This Offer?

In the opening pages of Startup Boards (18-20), we are treated to a (common) M&A drama:

• A later-stage company (let’s call them “GoodCo”) gets an acquisition offer. The deal would be attractive in the eyes of management and “Early VC” investors, who want to do the deal.

• BUT, “Late VC” just invested and joined the Board as a Director. Late VC’s firm would only get their money back (1x) on the deal, and accordingly would rather keep growing the company.

• Importantly, continuing to grow the business is an option for GoodCo. GoodCo has fresh cash (from Late VC of course) and a good enough business to warrant an offer. In other words: it’s still working.

How do you weigh such an M&A offer as a Board member? How do your fiduciary duties apply here?

These are some of the most critical questions to get right as a Board member. And it is where everyone - including the very smart authors of Startup Boards - mix up their duties.

“Support the Sale” Analysis

The Startup Boards authors explain how the Early VC reminds Late VC that they have “a fiduciary duty to all shareholders.”

And then later, the authors observe Late VC could have supported the transaction “in [their] capacity as a board member.”

The clearly implied takeaway is that a fiduciary duty would imply supporting the transaction.

Except, this is not quite right.

All else being equal, the fiduciary duty of Directors here should be to continue operating the business.

Charter Primacy: Loyalty to Continuing the Corporation

Directors of a Delaware Corporation owe their fiduciary duty first and foremost to the Corporation as a separate and independent legal entity.

See Guth v. Loft (1939) [predecessor to Pepsi] (“The rule that requires an undivided and unselfish loyalty to the corporation demands that there shall be no conflict between duty and self-interest.” https://h2o.law.harvard.edu/collages/4308)

Let that sink in: the duty is owed to the Corporation. Not individual shareholders, who are contractual third-parties to the Corporation.

While even Delaware courts have been muddy on this at times, it’s actually the most legally correct for purposes of a privately held Delaware corporation that is a going concern. (Startup Boards gets this right elsewhere in the book.)

Authorizing the sale of a Corporation in this context means the company’s death as a legal person. Whatever mission, chartered purpose, implied purpose, or otherwise, serving the Corporation means keeping it alive above all else (DGCL defaults to “perpetual” existance).

Since July 3, 1967, the DGCL (DE business law) has permitted “general incorporation” clauses which reads something like “The purpose of this corporation is to engage in any legally permissible purpose under the laws of the State of Delaware.” This replace what used to be very long-form statements of corporate purpose, for better or worse.

It’s an ambiguous mandate, but to honor such a Corporation’s charter in word and in spirit, a Director would have to loyally and with care keep engaging in legally permissible things under the laws of the State of Delaware.

Practically, what this means is that anyone who wants to see the company keep going - from other Founders to the latest investor - have a very strong case to be made that it is the fiduciary duty of every director to perpetuate the company’s existence. That would include not selling it, if it doesn’t need to be sold.

Moreover, in this Startup Boards story, it is management and the Early VC that are in potential breach of their fiduciary duties to the Corporation. As Startup Boards write, “the founders and Early VCs want to cash in.” But that’s exactly not the fiduciary mindset. In fact, it’s a conflicted mindset that could even constitute a breach of those duties. Startup Boards should have called that out for the benefit of its readers.

The Late VC is also clearly thinking about their fund economics and exercising a contractual blocking right their fund has as a shareholder. It is also the opposite of a correct fiduciary approach here. If this were a test of “Q: which hypothetical VC knows their duties?”, the answer would be “None of the Above.”

So there you have it folks: a hypothetical situation posed by the smartest VC/founder directors on the block, in the ‘locus classicus’ Startup Boards… and the teaching is wrong.

Simply put: the fiduciary obligation of all Directors here - in their capacity as Board members - would be to continue growing the company as best they could.

Anything else would be an exception (requiring some justification of the interests) or the exertion of contractual rights by shareholders (who do not have the same fiduciary duty).

Shareholder (Value Maximization) Primacy: An Incorrect Theory, Incorrectly Applied

The reason Startup Boards didn’t get it quite right (I think) is because many people believe (wrongly, as a matter of Delaware law) in the “theory of shareholder value maximization.” And if you’re a Director or Officer, incorrectly applying this false theory can get you into trouble in exactly these cases.

The maximization theory is a vestige of the old Chicago School of economics that since the 1960’s has gradually wormed its way into the heads of many a young MBA, Delaware judge, and naturally most self-described Capitalists. I admit, I got the indoctrination too on Park Avenue.

Let’s leave aside that it’s wrong on multiple levels. The theory is laughably misapplied, all the time, by smart people who believe it.

In this Startup Board vignette, it would appear that Early VC is arguing (uncontested) that maximizing shareholder value means taking the acquisition offer and not continuing to build the business.

Think about that. Say the company is worth $100mm at the time of the offer, and could reasonably grow 20-30% over the next year (a classic late-stage hurdle rate), such that it would reasonably be expected to be worth ~$125mm a year later.

What’s bigger: $100mm or $125mm? Option B, right?

You are correct. Value maximization in this case would favor continuting the grow the company.

Why the authors of Startup Boards didn’t point that out - or have any smart character in their example do so - indicates that maybe nobody gets this quite right.

For any company that has any positive expected value in the future, any plain reading of ‘value maximization’ theory means you keep building.

Of course, the theory itself is wrong (mostly because it has no firm basis in the DGCL and is impossible to adjudicate in practice, whereas Charter/Contract Theory is based in DGCL and can be read simply as a matter of contract interpretation).

But if you do subscribe to it, let’s at least get the maximization function right.

Enter In Re: Trados Litigation (2013)

Now, Startup Boards can be excused for this one since it was just a hypothetical trifle meant to provoke thoughts and discussion about a common dynamic (which it did well, clearly). It actually treats the subject better in other places.

The real example that everyone should brush up on is a case known as Trados (2013) (https://h2o.law.harvard.edu/collages/4338). Trados-style situations are coming to a startup near you.

Trados dealt with a company very similar to GoodCo (above). They made translation software and it still exists today (proof-positive it was a going concern; https://www.trados.com/).

In this case, the Trados had revenues of ~$26mm for CY2004, was slightly profitable, and had sufficient cash to continue operating. In other words, it was a viable business.

The CEO had presented a plan for reaching ~$50mm over the next three years (~24% CAGR). It had averaged ~22% from 1999 to 2003 (tough years in the market) and while it only grew 4% in 2004, it was meeting its revenue plan for 2005 and was by all accounts a viable business.

But the preferred investors, for various reasons, were ‘under water’ on their preference (ie did not percieve much economic upside even if the business did grow).

So they arranged for a $60mm M&A sale (~2x revenue). Of that, $52.2mm went to preferred holders, and $7.8mm was paid to management incentive plan (effectively put in place to buy management participation).

The common holders got zero dollars.

But for the carve-out (arranged quite clearly to buy the votes), common would have received ~$2mm.

And if the business had operated to plan, growing from ~$30mm (2005) to ~$50mm (2007), common would have received ~$30mm on the same ~2x EV/Rev multiple at that point.

Think about that from a common shareholder perspective: common had a reasonable chance at something like $30mm in 2-3 years, and instead was forced to take zero.

Delaware Chancery Court Decides to Ignore Math

The court’s decision was perhaps the most talked about VC-fiduciary case ever. Every law firm and aspiring law student in the field of corporate governance wrote about this. Even Scott Kupor offers an analysis in his book.

The opinion by Vice Chancellor Laster an astounding collection of facts indicating 1) the majority of the Directors were in fact conflicted, and 2) failed to pursue any semblance of a ‘fair process’ in the conduct of the sale. It is hard to read the opinion and not think the Directors would be found in breach of their duties.

However, at the very end, the opinion concludes that the equity value had a ‘fair price’ of ‘zero’ since “Trados had no realistic chance of growing fast enough to overcome the [8% cumulative dividend on the ~$48mm preference].”

Did the Vice Chancellor ever attend math class?

The company had by all accounts, a ‘highly reasonable’ expectation of growing. It’s CEO (a defendant) and presented a plan for 24% growth, and it was on plan and profitable. It had put up ~22% for several years before.

And if the company had executed on this, it would have reasonably delivered ~$30mm to common shareholders in 2.5 years - instead of zero.

If you ever play a game of chance, or buy options, you know that a non-zero chance of any money at any point, at no additional cost to you, always has an economic value greater than zero.

If there was any case where the law of shareholder value maximization should have applied, it is here.

What Really Happened (I think)

Now, I believe the real (untold) story is that Vice Chancellor is actually quite good at math.

Here’s the math: Delaware gets ~25% of its state budget from its corporate franchise tax (which does not include all the indirect income from related business activities). The state has worked hard to earn the #1 jurisdiction on Earth for incorporating your company, mostly through a level-headed business code that balances management and shareholder interests.

The Vice Chancellor could not show up at his golf club if he found (correctly) a breach of fiduciary duty by a group of VCs from central casting (e.g. Sequoia). Especially given conduct, that probably is not rare (ie overlooking fiduciary duties in favor of their own self-interest). It might have tilted too far in favor of the common shareholder, perhaps driving away private equity investors and hurting the state coffers. Delaware is very sensitive to landing the balance well.

So instead, he delivered all the punches except the knock-out blow. He even advocates for fee-shifting (ie charging the defendants legal fees for frivolous actions and bad faith behavior). He also loaded the record with plenty of material for appeal. In the end, the case settled - before an appeal - at an amount quite similar to what I calculated the “real math” economic damages might have been.

Basically, the court kept Delaware “safe” for VC directors and the defendants were directed into the backroom to pay up quietly out of the view of the public.

Vice Chancellor Laster was (I hope) excused from penning one of the most illogical holdings. And nobody was forced to correct the decision on appeal.

That’s all just conjecture, for the record Your Honor. It is what I believe most rational judges would have done in that situation.

A Fiduciary Duty to Build

The big take-away here is this: whether you believe in the theory of the contract or the false-god of ‘shareholder value maximization’, the most clear interpretation of a Board member’s fiduciary duty to a growing and economically viable Delaware corporation… is to keep building the company.

It’s the decision to sell such a company that is the potential breach and the exception - ie the exact opposite of how it was positioned in Startup Boards.

A few bonus take-aways if you made it this far:

• These “intermediate outcomes” are perhaps the most likely to be litigated (the Trados opinion points this out explicitly - and the Court of Chancery would know).

• If you are a Director or Officer in any company like this, you should be running your Board “buttoned up” and doing everything correctly and well-documented.

• Don’t be fooled by analysis that the Trados decision - by letting the Board off the fiduciary hook - was a green-light on such self-dealing behavior; the bad-actors in Trados did pay up in the settlement, legal fees, and certainly a reputational and emotional tax.

• If you’re on a Board that does decide to authorize a sale of such a company (ie growing, viable one), make sure you follow a fair process, arrive at a fair price, and importantly ensure the support of the whole board and all shareholders (to the maximum extent possible). Please, do retain the advice of good counsel.

Grateful to Brad, Mahindra, and Matt (+ teams) for the great book. The story above wasn’t the most off-base example I’ve read; but I do think it was a missed opportunity to teach the correct way of thinking like a fiduciary for a company.

My hope is that in v3.0, some element of this analysis can make its way into the good book. For the sake of Delaware law, and math, it deserves to be taught correctly.